How One Small-Cap Fund Is Making a Graceful Exit From Technology

What a difference a month makes. Through the first quarter, the (SCTGX Quote)Scudder 21st Century Growth fund was up 13% -- on top of a 125% gain last year -- far outstripping its small-cap peers and looking every bit like the five-star fund Morningstar says it is.

Then came Judgment Day in tech land. Now, the fund is down 7% in the year to date. Its 50% technology stake at year-end (62% if you include tech stocks that Morningstar puts in the service and manufacturing categories) has shrunk to 35% of assets.

Lead portfolio manager Peter Chin has the market gods to thank -- of course -- for some of that markdown. (He actually blames Fed Chairman Alan Greenspan.) But much of the tech cutback has been by design, as Chin started swapping tech holdings for calmer fare late last year and early in the first quarter.

Will a new focus beyond tech restore the fund's five-star luster? Chin, whose fund ranked among the top 10% of its peers last year and among the top 17% over the past three years, clearly thinks so. In any case, his recent moves, which he detailed in an interview earlier this week, should prove instructive for individual investors trying to navigate this radically changed environment for technology and small-cap stocks.

Top Holdings on Dec. 31, 1999
Stock	Sector	Price-to-Earnings Ratio
Commerce One (CMRC Quote)	Technology	N/A
Mercury Interactive (MERQ Quote)	Technology	192
TSI International Software (MCTR Quote)	Technology	N/A
DoubleClick (DCLK Quote)	Technology	N/A
Research in Motion (RIMM Quote)	Technology	405
PMC Sierra (PMCS Quote)	Technology	268
Network Appliance (NTAP Quote)	Technology	375
Pinnacle Systems (PCLE Quote)	Technology	65.5
Whittman-Hart (MRCH Quote)	Services	44.6
Vitesse Semiconductor (VTSS Quote)	Technology	226
Source: Scudder 21st Century Growth, Morningstar

Chin's changes start at the top. In fact, three of the fund's big tech stakes have vanished from his top 10 holdings: Commerce One (CMRC Quote), PMC Sierra (PMCS Quote) and Vitesse Semiconductor (VTSS Quote).

"We started to peel back in December and January. That hurt me then but it's probably helped me today." Chin says Commerce One was a 10-bagger for him, purchased at last July's initial public offering at a split-adjusted 3/12. He loaded up again around 10 and sold in late December, early January in the 100s. Though the stock has tumbled since, Chin says he didn't sell for fundamental reasons, but only because a $15 billion market capitalization was way too big for his small-cap portfolio. Ditto PMC Sierra and Vitesse Semiconductor.

Top Holdings on April 20, 2000
Stock	Sector	Price-to-Earnings Ratio
Silicon Storage Technology (SSTI Quote)	Technology	N/A
Pinnacle Systems (PCLE Quote)	Technology	66.4
ISS Group (ISSX Quote)	Technology	395
Mercator Software (MCTR Quote)	Technology	N/A
Antec (ANTC Quote)	Industrial Cyclicals	39.3
Polycom (PLCM Quote)	Technology	80.5
Mercury Interactive (MERQ Quote)	Technology	192
Power-One (PWER Quote)	Technology	130
Asyst Technologies (ASYT Quote)	Technology	N/A
Copart (CPRT Quote)	Services	37.2
Source: Scudder 21 Century Growth

Clearly, there's a lot of tech left in Chin's top 10. But he now says a 35% weighting -- slightly above the 31% tech weighting of the S&P 500 index -- is now as much as he wants. "The nontech gives us balance. And what tech we're looking at, we're being a lot more careful about profitability."

Profits? Now there's a concept.

"I'm from the old school," says Chin, who joined Scudder back in 1973. "I believe earnings count, earnings matter, P/Es matter. A year ago people talked about price-to-sales ratios. Six months ago it was all about getting market share. Now we're back to price-to-earnings."

That's not to say that all of Chin's holdings now are low-multiple issues with long track records -- he is a small-cap manager specializing in emerging growth stocks, after all. But Chin says he won't wait long -- two years, max -- for profits. "I don't care how sexy it looks. I'm just not gonna do it because too many things can happen in three years."

The fund has eight small-cap analysts combing the country for possibilities and visiting companies at least once a quarter to make sure things are on track. Chin wants leaders in niche markets with proven managers and a plan for financing growth -- the latter especially key now with the IPO window closing because of market volatility. Chin will begin a position at about 1% of assets and trim anything that grows beyond 4% -- or that far exceeds the fund's $2 billion market-cap limit.

Here's a peek at what Chin has been buying lately among nontech names and formerly pricey tech names that look like bargains now.

Copart (CPRT Quote) is the new No. 10 on Chin's top holdings list. The company takes cars that have been in wrecks and cleans them up to sell at auction for insurance companies. Last year the company started auctioning vehicles online, boosting demand and increasing the prices fetched.

T-shirt maker Gildan Activewear (GIL Quote) is the No. 11 holding. When the Canadian company came to Chin two years ago peddling its IPO, Chin said to himself, "T-shirts? C'mon, I'm tech, I'm high-growth." But early last year, impressed by productivity gains that were boosting profit margins with nary a price increase, Chin bought stock in a secondary offering at 12. When new cash comes into the fund, he buys more. And the recent uptick in inflation isn't all that bad -- in January the company hiked prices 3%, the first increase in five years.

New York-based drug store chain Duane Reade (DRD Quote) is among the fund's most recent stakes. The company's top line is growing at 20% a year, its bottom line at 25%. It's got a price-to-earnings multiple in the 13 to 15 range and is a leader in its marketplace. The icing on the cake? Speculation that the company is a takeover target for any of the big chains trying to make a footprint in New York City.

Alpha (AHAA Quote), a fast-growing semiconductor company that ranks Motorola (MOT Quote) as one of its biggest customers, is among Chin's tech bargains. "We always wanted to buy it but it was too big for us." Down from a peak around 80, Chin started buying in the 40s, stopped when the stock bounced back and then bought more when the Nasdaq tumbled anew.

National Information Consortium (EGOV Quote) is a leader in government-to-consumer Internet services. It has 105 states, cities, counties and government entities on its site, so consumers can apply for licenses and whatnot online without waiting in line. The stock peaked in the 70 range; Chin has added to his position at around 12 and 13.

Viador (VIAD Quote), which makes software for business-to-business information exchange, was also attractive but too expensive for Chin until the last couple of weeks brought the stock down to the teens from a peak in the low 60s. A slowdown in the IPO market is giving Viador some breathing room, since it's unlikely still-private competitors will be able to tap the equity markets for the financing they need to expand.

Who knows, if Chin succeeds in bringing his fund back to the ranks of the top performers, maybe Gildan will print a special T-shirt for him: "I survived the tech wreck of 2000."